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Debt dilution and sovereign default risk

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  • Juan Carlos Hatchondo
  • Leonardo Martinez

Abstract

We measure the effects of debt dilution on sovereign default risk and show how these effects can be mitigated with debt contracts promising borrowing-contingent payments. First, we calibrate a baseline model à la Eaton and Gersovitz (1981) to match features of the data. In this model, bonds' values can be diluted. Second, we present a model in which sovereign bonds contain a covenant promising that after each time the government borrows it pays to the holder of each bond issued in previous periods the difference between the bond market price that would have been observed absent current-period borrowing and the observed market price. This covenant eliminates debt dilution by making the value of each bond independent from future borrowing decisions. We quantify the effects of dilution by comparing the simulations of the model with and without borrowing-contingent payments. We find that dilution accounts for 84% of the default risk in the baseline economy. Similar default risk reductions can be obtained with borrowing-contingent payments that depend only on the bond market price. Using borrowing-contingent payments is welfare enhancing because it reduces the frequency of default episodes.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Richmond in its series Working Paper with number 10-08.

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Date of creation: 2012
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Handle: RePEc:fip:fedrwp:10-08

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Keywords: Business cycles ; Financial institutions ; Financial markets;

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Citations

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Cited by:
  1. Gonçalves, Carlos Eduardo & Guimarães, Bernardo, 2012. "Sovereign default risk and commitment for fiscal adjustment," CEPR Discussion Papers 9163, C.E.P.R. Discussion Papers.
  2. Hatchondo, Juan Carlos & Martinez, Leonardo & Sosa Padilla, César, 2014. "Voluntary sovereign debt exchanges," Journal of Monetary Economics, Elsevier, vol. 61(C), pages 32-50.
  3. Juan Carlos Hatchondo & Francisco Roch & Leonardo Martinez, 2012. "Fiscal Rules and the Sovereign Default Premium," IMF Working Papers 12/30, International Monetary Fund.
  4. Cesar Sosa-Padilla, 2012. "Sovereign Defaults and Banking Crises," Department of Economics Working Papers 2012-09, McMaster University.
  5. Juan Carlos Hatchondo & Leonardo Martinez, 2013. "Sudden stops, time inconsistency, and the duration of sovereign debt," IMF Working Papers 13/174, International Monetary Fund.
  6. John Hatfield & Fuhito Kojima & Yusuke Narita, 2012. "Many-to-Many Matching with Max-Min Preferences," Discussion Papers 12-020, Stanford Institute for Economic Policy Research.
  7. Satyajit Chatterjee & Burcu Eyigungor, 2012. "Debt dilution and seniority in a model of defaultable sovereign debt," Working Papers 12-14, Federal Reserve Bank of Philadelphia.
  8. Minetti, Raoul & Peng, Tao, 2013. "Lending constraints, real estate prices and business cycles in emerging economies," Journal of Economic Dynamics and Control, Elsevier, vol. 37(12), pages 2397-2416.
  9. Juan Carlos Hatchondo & Leonardo Martinez, 2012. "On the benefits of GDP-indexed government debt: lessons from a model of sovereign defaults," Economic Quarterly, Federal Reserve Bank of Richmond, issue 2Q, pages 139-157.
  10. Demian Pouzo & Ignacio Presno, 2012. "Sovereign default risk and uncertainty premia," Working Papers 12-11, Federal Reserve Bank of Boston.
  11. repec:fip:fedreq:y:2012:i:2q:p:139-157:n:vol.98no.2 is not listed on IDEAS

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